Investors are giving some stock pickers a chance

Thursday

Dec 26, 2013 at 12:00 PM

Stan Choe

Stock pickers are getting respect again. Well, some of them.

Respect in investing often is measured in dollars, and investors this year have been putting money into some actively managed mutual funds. But only a select few: Funds that focus either on smaller-cap stocks or on stocks that look cheaper than the rest of the market have attracted new investment.

Otherwise, investors are continuing their years-long migration toward index mutual funds. It’s a trend called passive investing, and it’s built on funds that aim to match the performance of a stock index, such as the Standard & Poor’s 500, rather than try to beat it. Fans of passive investing say selecting which stock pickers will do well is tough enough to begin with, and index funds have lower expenses to boot. Through the end of November, U.S. stock funds run by stock pickers have lost $10 billion this year through investor withdrawals, according to Morningstar.

Managers of small- and mid-cap stock funds, though, say they have several advantages over others that give them a better chance to beat their benchmark indexes. Among them:

• The risks are higher in small-cap stocks. Of the companies in the small-cap Russell 2000 index, 25 percent don’t make any money, says Nathan Moser. He is portfolio manager at the Pax World Small Cap fund (PXSCX), which has a five-star rating from Morningstar. Compare that with the large-cap S&P 500 index, where Moser says money losers make up only about 5 percent of the index.

A small-cap fund run by a stock picker can weed out those money-losing companies, focusing only on the profitable ones. The index fund, meanwhile, includes them all.

“If you’re a passive investor, you’re essentially saying you’re going to take a low-quality approach to investing,” Moser says. “While that may work over short periods of time, over the long term, you want to invest in quality.”

• Fewer analysts and investors are paying attention to small-cap companies. CoStar Group is one of the largest companies in the Russell 2000 index with a market value of about $5 billion. It has six financial analysts who follow it, predicting its earnings and giving recommendations to investors.

Microsoft, in contrast, has a market value of about $300 billion, and it has 35 analysts tracking it. That means whenever Microsoft does something — whether it’s developing a new product or reporting better-than-expected revenue growth — its stock price quickly reflects the news.

Because small- and mid-cap stocks get less attention, investors have a better chance of identifying stocks whose prices don’t yet fully reflect the potential earnings growth of the company, says Brian Lazorishak. He is a portfolio manager at the Chase Mid Cap Growth fund (CHAMX). The fund’s returns over the last 10 years rank in the top 25 percent of its category, according to Morningstar.

• Small-cap stocks are more expensive. Small company stocks have been the market’s best performers this year: The small-cap S&P 600 index has jumped 35.5 percent, compared with the S&P 500’s 26.9 percent climb.

But that also means that small-cap stocks as a group are pricier relative to their earnings. The S&P 600 is trading at 21 times its earnings per share over the last 12 months. The S&P 500, meanwhile, is trading at 16 times its earnings. A higher price-earnings ratio indicates a stock is more expensive, and managers say they offer an advantage over index funds by filtering out stocks with the highest ratios.

So how have investors fared if they chose mutual funds run by stock pickers? The recent track record is poor.

Over a five-year span through last June 30, only 22 percent of small-cap mutual funds beat the returns of the small-cap S&P 600 index, according to S&P Dow Jones Indices.

The numbers are roughly the same for funds focused on larger companies. Only 21 percent of large-cap funds beat the S&P 500, and only 18 percent of mid-cap funds topped the S&P 400 mid-cap index.

Stock pickers concede that the last few years have been difficult for them because stocks had been moving together in herds. Even if one company looked much stronger financially than another, both tended to move in the same direction: down when worries about the European debt crisis were flaring, for example, and up when the worries were receding.

“People were investing so thematically: Get me into gold miners, or get me out of financials,” says Bill Mann, chief investment officer at Motley Fool Asset Management. “But in any sector, there are good performers and bad performers.”

Stocks have begun to move more independently, as fear is no longer the primary driver for investors. Mann says that means he and other stock pickers are in a position once again to be rewarded for picking good stocks.

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